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Payment Processing Is Finally Getting the Upgrade It Deserves

May 10, 2019

If your friend owes you money for putting the dinner tab on his card, all it takes is a few clicks in the Venmo app and within minutes the money is in your account. It is one of the easiest ways to transfer money between people. Yet the backbone of Venmo and the entire American financial system—the main payment processing system the United States—still runs on the same schedule as when it was launched in 1974. This is the reason why when you get a paycheck on a Friday, the funds are not available until the following Monday or Tuesday. In October, the Federal Reserve put out a notice seeking comments on how the central bank could “support faster payments in the United States.” While this upgrade is still in its early stages, the Federal Reserve needs to make a massive change in how payments are processed in the United States. The Fed should correct some of the system’s regressive components and make the system quicker and more consumer-friendly.

Since its debut in 2009, Venmo (and its rivals like Zelle and Square Cash) has become one of the main means by which people pay one another. In 2018 alone, Venmo moved $62 billion between users.[1] By 2022, Venmo, Zelle, and Square Cash are estimated to have a combined 111 million users (nearly 1 in 3 Americans).[2] You can even now use Venmo with some major retailers like J. Crew and Lululemon.

Venmo works by setting up its own payment network amongst users that exists independently from the conventional banking system. A user connects a debit card, a credit card, or bank account to Venmo, and people within the Venmo platform send each other money. When a user pays someone, the app pulls those funds out of one’s Venmo account balance and then draws on whatever source the user connected. Payments within the app are nearly instant, while those that rely on the bank can take two or three business days to clear.

In the United States, the majority of financial transactions are handled through the automated clearinghouse (ACH) system. The ACH system “is a nationwide network through which depository institutions send each other batches of electronic credit and debit transfers… [T]he network is today being used extensively to process one-time debit transfers, such as converted check payments and payments made over the telephone and Internet.”[3] While Venmo moved $62 billion last year, the ACH facilitated $43 trillion worth of payments.[4]

The ACH takes days to provide users with access to their paychecks. Right now, under the ACH system, “if you deposit checks totaling more than $200, you can access $200 the next business day, and the rest of the money the second business day.”[5] Even though the modern economy has moved well beyond the traditional nine to five, Monday to Friday schedule, the current payments regime still exists as a relic of a bygone era. The Federal Reserve is beginning to build a system that provides households and businesses that ability to manage their money in real time.

The Automated Clearinghouse has placed an undue burden on Americans on account of its constrained operating hours. This system is “regressive because U.S. families with cash flow constraints spend billions in overdraft fees waiting for checks to clear over a weekend or holiday.”[6] Banks take advantage of the amount of time it takes for a check to clear by reordering pending payments in order to maximize overdraft fees.[7] A Brookings study concluded that “the result is that people who are living paycheck to paycheck run up overdraft fees thinking that their check cleared when in fact the money isn’t there and the debit card keeps working.”[8]

The automated clearinghouse system was created decades ago when checks had to be transported around the country and counted. The Federal Reserve operates the “black box that converts things like your debit-card swipes and direct-deposit paycheck into credits and deductions from your bank account.”[9] This makes the Fed the final authority on how payments move around in the country. Furthermore, the Fed writes the rules for other payment systems, including the bank-to-bank clearinghouses. This leads to an odd situation in which the Fed acts as both the operator and regulator of payment processing. According to Aaron Klein, a fellow at the Brookings Institution, this “can create a conflict of interest, especially given the Fed’s additional responsibility to ensure that the banking system is safe and secure.”[10] While the current system may be slow, it has experienced few failures or major disruptions over the years. As a result, the payments system has rarely caused serious consideration and debate.

On account of the system’s reliability and the Fed’s ability to control payment processing through regulation, the Fed has had little incentive thus far to modernize the ACH system. When the ACH system was created in the 1970s, Congress gave the Fed the authority to set the amount of time it takes payment to clear.[11] Congress has never revoked the authority even as technology has evolved, and as a result, the Federal Reserve has never been pressured to speed the process up. Klein has emphasized that it will take the Fed years to move to a new system, and without a Congressional mandate, there is no impetus for the Federal Reserve to move quicker. Until recently, there has not been enough political pressure to change the ACH system. Recently, major corporations including Walmart and Target as well as the Congressional Black Caucus have called on Congress to reassert its authority and order the Fed to build a better system.[12][13] This public campaign has raised public perception of issues with the system and seems to have encouraged the Fed to begin seriously considering building a new payments platform.

Should the Federal Reserve still operate the largest payment processing system? Or should it only write the regulations that govern how money moves in America? How will the new system work? The Fed will need to address these questions as it develops the new system. One example it can turn to is India’s new payment system.

In 2016, India rolled out a new Universal Payments Interface (UPI). UPI “opens up access to real-time by allowing payments to be directly integrated into external business applications.”[14] The National Payments Corporation of India, a non-profit consortium of the major Indian banks, runs the UPI system. The Reserve Bank of India, the nation’s monetary policy authority, holds multiple seats on the board of the NPIC and helps set its policies. Through the NPIC, the Reserve Bank of India has a say in how the corporation runs the nation’s payment infrastructure. UPI’s adoption in India has led to numerous new innovations: transactions are settled instantly, users can use just their smartphones to bank (no need to go to a bank in person to open an account), and people can send money using only mobile numbers. The results of the UPI system’s uptake have been impressive.“ Transactions using UPI increased 100 times from a modest 92,000 to 9.2 million transactions in the first nine months of operation.”[15] Payments are quicker and money changes hands more frequently.

The Federal Reserve has the opportunity to implement a similar solution in the United States. By decreasing transaction costs, the Federal Reserve may be able to pass on the savings to consumers and make some charges, like overdraft fees, a thing of the past. Thanks to the unilateral authority Congress gave it in the 1970s, the Federal Reserve has never been pressured to improve the payment system until recently. As it moves forward, the Fed will need to balance convivence with safety and security. The Fed has the opportunity to improve upon the outdated components of the ACH and provide the country with a modern and efficient payment processing system.

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

References

   [1]https://investor.paypal-corp.com/static-files/d7789358-2196-4799-8e0e-a3c3355407f3

   [2]https://techcrunch.com/2018/06/15/zelle-forecast-to-overtake-venmo-this-year

   [3]https://www.federalreserve.gov/paymentsystems/fedach_about.htm

   [4]https://www.nacha.org/ach-network/timeline

   [5]https://www.consumerfinance.gov/ask-cfpb/how-quickly-can-i-get-money-after-i-deposit-a-check-into-my-checking-account-what-is-a-deposit-hold-en-1023/

   [6]https://www.marketwatch.com/story/say-goodbye-to-bank-overdraft-fees-fed-begins-work-on-real-time-payment-system-2018-10-03

   [7]Servon, Lisa J. 2017. The Unbanking of America: How the New Middle Class Survives.

   [8]https://www.brookings.edu/opinions/why-dont-checks-clear-instantly-ask-the-fed/

   [9]https://www.brookings.edu/opinions/why-dont-checks-clear-instantly-ask-the-fed/

   [10]https://www.brookings.edu/opinions/why-dont-checks-clear-instantly-ask-the-fed/

   [11]https://spotlightonpoverty.org/spotlight-exclusives/real-time-payments-can-help-combat-inequality/

   [12]https://www.wsj.com/articles/for-walmart-and-target-the-fed-holds-the-keys-to-faster-payments-1544097601

   [13]https://www.americanbanker.com/news/congressional-black-caucus-members-urge-fed-action-on-faster-payments

   [14]http://empower1.fisglobal.com/rs/650-KGE-239/images/FIS_Flavors_of_Fast_2017.pdf

   [15]http://empower1.fisglobal.com/rs/650-KGE-239/images/FIS_Flavors_of_Fast_2017.pdf

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  • <h3>Federal Reserve Economic Data (FRED®)</h3><p><strong><img width="180" height="79" alt="" src="/live/image/gid/4/width/180/height/79/481_fred-logo.rev.1407788243.jpg" class="lw_image lw_image481 lw_align_right" data-max-w="222" data-max-h="97"/>An online database consisting of more than 72,000 economic data time series from 54 national, international, public, and private sources.</strong> FRED®, created and maintained by Research Department at the Federal Reserve Bank of St. Louis, goes far beyond simply providing data: It combines data with a powerful mix of tools that help the user understand, interact with, display, and disseminate the data.</p><p> Quick link to data page: <a href="http://research.stlouisfed.org/fred2/tags/series" target="_blank">http://research.stlouisfed.org/fred2/tags/series</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
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